Sunday, June 27, 2010

Contrarian Investment Strategies - The Next Generation: Chapter 9

The founder and Chairman of Dreman Value Management (est. 1977) shares his views on how investors can beat the market with this book (written in 1998). In reference to the efficient market hypothesis (EMH), Dreman writes "Nobody beats the market, they say. Except for those of us who do." More on this book is available here. One of his earlier books (from 1982) has already been summarized here.

Dreman expands a bit on the low P/E strategy described in the previous chapter. His research suggests that the low P/E strategy even works (by a similar margin) within individual industries, which opens up many doors for investors who can't help but avoid unfavoured industries. As a result, Dreman argues that the investor can even participate in the most popular industries of the day, and buy the companies within that industry that trade at the lowest P/E (even if those stocks trade at premiums to the market) and still generating returns that are much stronger than that of the market!

Dreman also discusses the very difficult question of when to sell an investment. There are as many answers to this question as there are investors, Dreman argues. Furthermore, few stick to their sell targets, thanks to psychological forces. For instance, if a stock rises up through the target sell price set by the investor, he will tend to find reasons to bump up his valuation.

Dreman provides a rule for investors to follow that he highly recommends investors stick to. He advises that investors sell once the stock's valuation level has reached that of the market. For example, if the investor is following a low P/E strategy, he should simply sell when the stock is at the same P/E level of the market, and use the funds to buy a new contrarian stock.

Another difficult question to answer is when to give up on a stock that doesn't see any improvement in its valuation. Dreman advises that investors give a stock 2.5 to 3 years, or more if it's a cyclical stock (as it may take more time to recover from an economic slowdown). Other investors use different time periods, however, so the investor may need to reach his own decision on how comfortable he is with his "loser" investments. For example, value investor John Templeton will give his investments six years to come around (assuming no change in fundamentals).